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Question By Mike
"What Happens If Short Leg of Put Spread Exercised?"
I would like to start using a put spread strategy however I have never actually sold an option to open before. I would like to know what would happen if, in the case of a put spread, I get exercised on the put I sold? Do I need to make sure I have 100 shares of the underlying stock for every contract I sold in my account or will my broker just debit my account?
Asked on 10 May 2012
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Answered by Mr. OppiE
Hi Mike,
There are two main kinds of put spreads; Bear Put Spread and Bull Put Spread. The Bear Put Spread is a debit spread that involves buying a higher strike put option and then writing lower strike put options in order to reduce capital outlay on the purchase of the long put options. The Bull Put Spread is a credit spread that involves buying a lower strike put option and then writing higher strike put options in order to speculate on the underlying asset closing higher than the short put options.
I am not sure which specific put spread you are referring to but both put spreads involve writing (Sell to Open) put options and therefore the possibility of those short put options going in the money and getting assigned. Yes, short put options only run the risk of assignment when they get in the money. The deeper in the money and the closer to expiration, the higher the chance of your short put options getting assigned (the proper term for your short options getting involuntarily exercised).
When you write put options, you are selling the right to sell you the underlying stock at the strike price. This means that when you write put options, even as part of a put spread, you are obligating yourself to buy the underlying stock at the strike price should the buyer of the option chooses to do so. Of course nobody would exercise an out of the money option. That is why the chances of assignment only exist when the short put options are in the money.
When short put options are assigned, you will buy the underlying asset from the buyer of the option and therefore end up with shares of the underlying stock paid for with cash in your options trading account. If you are trading a Bull Call Spread, your broker would require you to have an amount of cash to back up such an assignment (known as "margin") due to the fact that it is a credit spread. So you would most likely already have the cash available to take physical delivery of the underlying stock when the short put options are assigned. However, if you are trading a Bear Put Spread, you might not have the cash available to take delivery due to the fact that no margin is required for debit spreads. In this case, should your short put options be assigned, your options broker would most likely sell the resultant stock position in the open market instantly and post the difference (profit/loss) in cash in your options trading account.
What Happens If Short Leg of Put Spread Exercised?
Bull Put Spread
Assuming you wrote 1 contract of AAPL's January $190 put options when AAPL was trading at $190 for $3.20 and bought 1 contract of AAPL's January $180 put options for $1.20, making a Jan 190/180 Bull Put Spread with net credit of $3.20 - $1.20 = $2.00. A margin of $20,000 was required for this position so you held $20,000 cash in your account.
Assuming AAPL drops to $170, taking the $190 put options $10 in the money and assigned near expiration. You get 100 shares of AAPL bought for $190 per share and paid $19,000 for it leaving your account with the shares, $1,000 cash balance and the long $180 put options. As the AAPL shares are bought at $190, it post an immediate loss of $20 per share as it is trading at $170.
Bear Put Spread
Assuming you bought 1 contract of AAPL's January $190 put options when AAPL was trading at $190 for $3.20 and wrote 1 contract of AAPL's January $180 put options for $1.20, making a Jan 190/180 Bear Put Spread paying a net debit of $3.20 - $1.20 = $2.00. No margin is required for the position as it is a debit spread and you have no cash balance left in your account.
Assuming AAPL drops to $170, taking the short $180 put options $10 in the money and assigned near expiration. You get 100 shares of AAPL bought for $190 per share and because you do not have the cash to pay for the stocks, your broker would immediately sell the shares at the market price of $170, making an immediate loss of $20 per share for a total of $2000. Since you do not have the cash to pay for the $2000 loss, your broker would also liquidate your long $190 put options, selling it for a profit of $20 per contract as it is $20 in the money, thus offsetting the $2000 loss.
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In conclusion, even though short put options are assigned the very same way when they get in the money by expiration or near expiration, the outcome can be very different depending on whether it is a credit or debit put spread. If you are unfamiliar with these outcomes and how they work out in a trading account, you might want to virtual trade your strategy for a significant amount of time and experience safely how such assignment work out before trying for real. Almost all options trading accounts come with virtual trading platforms.
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